On his inauguration in 2009, Barack Obama inherited a massive headache from the GFC. With unemployment stubbornly above 9 percent, efforts to create new jobs have so far proved futile.
- Low interest rates from the Fed failed to stimulate new investment. Richard Koo coined the phrase balance-sheet recession to describe private sector reaction to a financial crisis. Low interest rates have as much effect as pushing on a string. Corporations and households alike have no wish to borrow in the face of falling asset prices and erosion of their own balance sheets — and banks have little desire to lend.
- Quantitative easing failed to lower long-term interest rates and stimulate employment. Instead it revived inflation expectations, creating a surge in commodity prices.
- The trade deficit widened despite the falling dollar, reflecting an inability of US exports to compete in offshore markets — and a loss of manufacturing jobs as foreign exporters made inroads into US domestic markets.
- Fiscal stimulus, whether through tax cuts or spending on education or infrastructure not only failed to create sustainable jobs but has left the taxpayer with a mountain of public debt.
- The home construction industry, a major employer, remains stagnant. Inventories of new and existing homes amount to more than 12 months sales at current rates — when one includes “shadow inventory” of homes repossessed, in foreclosure, or with mortgages delinquent for 90 days or more.
Deflation threat
When the housing bubble collapsed, households and corporates were threatened by falling values and shrinking credit. Savings increased and were used to repay debt rather than channeled through the financial system into new capital investment. A deflationary gap opened up between income and spending: repaying debt does not generate income as new capital investment does. The gap may appear small but, like air escaping from a punctured tire, can cause significant damage to overall income levels as it replays over and over through the economy. The only way to plug the gap is for government to spend more than it collects by way of taxes, but the result is a sharp increase in public debt.
Five point plan
Companies are unwilling to commence hiring until consumption increases — and consumption is unlikely to increase until employment levels rise. The only solution is to create sustainable jobs while minimizing borrowing against future tax revenues.
- Stop importing capital and exporting jobs.
Japan and China have effectively maintained a trade advantage against the US by investing more than $2.3 trillion in US Treasuries. The inflow of funds on capital account acts to suppress their exchange rate, effectively pegging it against the greenback. Imposition of trade penalties would result in tit-for-tat retaliation that could easily escalate into a trade war. Capital flows, however, are already tightly controlled by China and others, so retaliation to capital account controls would be meaningless. Phased introduction of a withholding tax on foreign investments would discourage further capital inflows and encourage gradual repatriation of existing balances over time. Reciprocal access to capital markets could then be negotiated through individual tax treaties. - Clear excess housing inventories.
Supporting prices at current levels through low interest rates will prevent the market from clearing excess inventory. Stimulating demand through home-buyer subsidies would achieve this but increases public debt and, as Australia discovered, leaves a “shadow” of weak demand if the subsidy is later phased out. Allowing home prices to fall, on the other hand, would clear excess inventory but threaten the banking sector. Shoring up failing banks also requires funding, although this could be recovered over time through increased deposit insurance. - Increase infrastructure spending.
Infrastructure projects should not be evaluated on the number of jobs created but on their potential to generate future revenue streams. Whether toll roads or national broadband networks, revenue streams can be used to repay public debt. Projects that generate market-related returns on investment also open up opportunities for private sector funding. Spending on education and community assets should not be funded with debt as they provide no viable revenue streams for repayment. The same goes for repairs and maintenance to existing infrastructure — they should be funded out of current tax revenues. Similarly, research and development of unproven technologies with open-ended budgets and uncertain future revenues. - Raise taxes to fund infrastructure investment.
Raising taxes to repay debt, as FDR discovered in 1937, has the same effect as a deflationary gap in the private sector and shrinks national output. But raising taxes to fund infrastructure investment leaves no deflationary gap and increases the overall level of capital investment — and job creation — within the economy. - Increase austerity.
Cutting back on government spending merely re-opens the deflationary gap between income and spending. Reducing regular spending in order to free up funds for infrastructure projects, however, would leave no deflationary gap while accelerating job creation within the economy.
Bi-partisan approach
The magnitude and extent of the problems facing the US require a truly bi-partisan approach, unsuited to the rough-and-tumble of a vibrant democracy. Generational changes are required whose impact will be felt long after the next election term. It will take true leadership to forge a broad consensus and set the US on a sound path for the future.
Published in the November issue of Charter magazine.
